Journal Issue
Share
Article

United States of America: Selected Issues

Author(s):
International Monetary Fund
Published Date:
July 2004
Share
  • ShareShare
Show Summary Details

III. United States: Perspectives on Fiscal Consolidation31

1. The administration has committed itself to reducing the fiscal deficit to below 2 percent of GDP by the end of the decade.32 Following a substantial widening in recent years, this would bring the budget deficit below its long-term average relative to the size of the economy, but fall short of the administration’s initial objective of maintaining an overall surplus equal to that of the Social Security trust funds (OMB, 2001; Figure 1). Moreover, as a number of analysts have noted, the adjustment relies heavily on the effect of the cyclical rebound, the expiration of some of the recent tax cuts, and adherence to strict spending limits, with the deficit reduction after FY 2006 being relatively modest.

Figure 1.Medium-Term Fiscal Projections

Source: CBO.

2. Even if current budget targets were achieved, both the federal deficit and debt would remain high relative to the pressure on entitlement programs from the retirement of the baby boomers. As has been illustrated in recent staff analyses, more ambitious deficit reduction would have the advantage of providing greater room for addressing the underfunded position of entitlement programs, which experience suggests could require a long time to be fully implemented (Mühleisen and Towe, 2004).33

3. Most analysts agree that significant efforts would be required to reduce the deficit further. For example, a review of three different plans for fiscal consolidation contained in Rivlin and Sawhill (2004) suggests that expenditure cuts and revenue measures worth a combined $530 billion (3½ percent of GDP) per year could balance the unified federal budget over the next ten years. Edwards (2004a) proposes $300 billion (2½ percent of GDP) worth of annual expenditure savings to achieve the same target over five years. Balancing the budget excluding the Social Security surplus, which has been the IMF staff’s long-standing prescription, would require fiscal measures of up to 4 percent of GDP by the end of the decade.34

4. Against this background, this chapter reviews possible policy options for fiscal consolidation. As an introduction to the discussion, Section A draws parallels with consolidation in the 1990s, suggesting that current circumstances may be more difficult. Section B reviews the potential for spending cuts, while Section C discusses tax base-broadening and other measures to boost revenues. Section D review options that could be considered for generating short-term savings in the Social Security and Medicare programs.35

A. Lessons From the Last Fiscal Cycle

5. There are a number of important parallels between the current fiscal cycle and the expansion that occurred during the 1980s. In the earlier period, priority was given to boosting military spending, cutting taxes to strengthen the supply side of the economy, and stimulating activity in response to the 1981–82 recession. As a result, the fiscal deficit widened by 4½ percent of GDP between FY 1979 and FY 1983, reaching a peacetime low of 6 percent of GDP (Figure 2, next page). Similar priorities have caused an even larger shift in the budget balance in recent years, totaling 7 percent of GDP between FY 2000 and FY 2004.36 Although the overall deficit has not reached the same level as during the 1980s, the primary balance (i.e., excluding interest payments) has declined to a comparable level (Figure 3).

Figure 2.Receipts and Outlays of the Federal Government, 1977 - 2009

(In percent of GDP)

Source: OMB (2004).

Figure 3.Primary Fiscal Balance

Source: OMB (2004).

6. The two episodes differ in important ways, however, with the fiscal expansion in the 1980s primarily caused by higher spending. Federal expenditures rose by 3½ percent of GDP between 1979 and 1983, most of which resulted from an increase in entitlement spending (Figures 4 and 5). While defense expenditure also increased, this was partly offset by cutbacks in other discretionary spending categories.37 Altogether, outlays accounted for almost three-quarters of the deficit increase in the early 1980s, compared to less than a third in the recent fiscal expansion.

Figure 4.Comparison of Fiscal Position, 1977-88 and 1998-2009

(In percent of GDP)

Source: OMB (2004).

Figure 5.Change in Federal Receipts and Outlays, 1979 - 2009

(In percent of GDP)

Source: OMB (2004); and Fund staff calculations.

7. The revenue effect of the “Reagan tax cuts” was considerably smaller than in the current period. Among other measures, the Economic Recovery Tax Act (ERTA) of 1981 lowered marginal income tax rates by around one quarter across the board—contributing to a 2½ percent of GDP drop in personal income tax revenues over two years—and accelerated depreciation schedules, providing significant corporate tax relief. Although the short-term revenue loss caused by ERTA exceeded those in recent years, parts of this tax cut were quickly reversed as the fiscal position deteriorated in subsequent years (Penner, 2003; Steuerle, 2004; Tempalski, 2003).38 Personal income tax revenues therefore changed relatively little during the expansion in the early 1980s as a share of GDP, although corporate tax revenues declined by 1½ percent of GDP. By contrast, the more recent tax cuts have been largely targeted at households, with personal income tax revenues expected to fall by more than 3 percent of GDP between FY 2000 and FY 2004.

8. The fiscal position proved difficult to correct during the 1980s, despite strong economic growth. Federal revenues remained stable relative to GDP throughout the decade, owing to the economy expanding 4 percent on average between 1983 and 1989, and a series of legislated tax increases. Non-military discretionary spending cuts were sustained, and defense expenditure began to decline in the second half of the decade. Nevertheless, the deficit dipped only briefly below 3 percent of GDP in 1989, before being pushed up again by the 1991 recession, the costs of dealing with the S&L crisis, and the Gulf war. In structural terms, the deficit fell by around 1 percent of GDP during the late 1980s (Figure 6).

Figure 6.Budget Balance Adjusted for Cyclical Factors and Capital Gains Taxes1

Source: CBO.

1/ The CBO’s cyclically-adjusted balance has been altered by subtracting the difference between capital gains tax revenues and their long-term historical average.

9. It took tax hikes, a sharp contraction in military spending, and an unprecedented economic expansion to achieve fiscal consolidation. The fiscal improvement between 1992 and 2000 amounted to about 4½ percent of GDP in structural terms, leaving the budget in surplus even after excluding Social Security. Contributions from the revenue and expenditure side were about equal:

  • Individual income tax receipts rose by 2¾ percent of GDP, propelled by an increase in top marginal tax rates in the 1993 Omnibus Budget Reconciliation Act, strong income growth especially in the higher tax brackets, and a booming stock market.

  • Defense spending was roughly cut in half as a share of GDP from its peak during the 1980s and the end of the 1990s, accounting for the bulk of expenditure reduction. Nondefense discretionary outlays were also contained, owing in large part to the spending caps imposed by the 1990 Budget Enforcement Act. Mandatory outlays even fell somewhat, benefiting from a temporary drop in fertility rates during the Great Depression that affected the number of retirees 60 years later (Penner, 2003). Finally, a decline in interest rates and the shrinking public debt ratios caused net interest payments to drop by almost 1 percent of GDP.

10. Present circumstances appear less favorable for fiscal consolidation. On the revenue side, the extension of the 2001 tax cuts, if enacted, would permanently lower tax receipts by about 2 percent of GDP. Moreover, with lower top marginal income tax rates and reductions in capital gains taxes, revenues would be less well positioned to benefit from economic buoyancy than in the 1990s should the economy exhibit a similar distribution of income gains in the coming years. Budget forecasts are also predicated on the Alternative Minimum Tax (AMT) being maintained in its present form, which is viewed as unlikely since the AMT will affect an increasing number of middle-class taxpayers over the coming years.39

11. On the expenditure side, many of the factors supporting fiscal consolidation in the 1990s are also no longer in place. Expenditure on defense and homeland security has increased after 2001, but remains far below the levels reached in the 1980s. Geopolitical uncertainties and security concerns are likely to persist over the foreseeable future, suggesting that large-scale reductions in this category are unlikely to materialize. Keeping a lid on mandatory spending also would appear more difficult as the retirement of the baby boomers is now imminent; and interest costs are projected to rise as the downward cycle in interest rates may have finally come to an end.

B. Containing Public Expenditure

12. The FY 2005 budget lays considerable emphasis on reversing recent increases in federal spending. Federal outlays have picked up since the late 1990s, reflecting weakening budget discipline in the face of strong revenue gains (de Rugy, 2004; Kell, 2004) and, more recently, the reaction to geopolitical developments. Outside defense and homeland security, spending rose mainly in entitlement programs, reflecting initiatives such as the No Child Left Behind Act for education and the introduction of a new prescription drug benefit for the Medicare program. The recent budget proposes to stiffen expenditure discipline considerably over the next five years. While spending on defense would be reduced to 3¼ percent of GDP, other discretionary outlays would drop to 3 percent of GDP by FY 2009, equivalent to a 2 percent per year decline in real terms (Table 1).

Table 1.Budget Outlay Projections
Discretionary OutlaysMandatory

Outlays
DefenseOther
(in billions of U.S. dollars)
FY 20044524571,314
FY 20094864571,692
(in percent of GDP)
FY 20043.94.011.5
FY 20093.33.111.5
Source: OMB (2004).
Source: OMB (2004).

13. This adjustment would further reduce government outlays from a level that is already low by international standards (Figure 7, next page). In comparison with other major industrial countries, U.S. non-military public expenditure and employment are low relative to the size of the economy. Excluding defense spending, which is much higher in the United States, U.S. government spending is about 10 percent of GDP below the G-7 average. While comparisons are also complicated by differences in the degree to which health spending and other public transfers affect public expenditure data, this suggests that the U.S. government sector is already relatively lean, which may make it difficult to identify expenditure savings of a large order of magnitude. Some analysts have also argued that genuine spending needs remain unfilled, for example, based on studies that suggest maintaining public infrastructure levels is necessary to underpin long-term growth prospects.40

Figure 7.G-7 Countries: Government Expenditure and Employment, 2003

Source: IMF, World Economic Outlook; and OECD.

14. Imposing spending discipline may be difficult in the absence of a robust medium-term expenditure framework. Congressional appropriations have typically exceeded initial budget proposals (Figure 8), which has been ascribed to efforts by members of Congress to secure federal spending for their constituencies (CAGW, 2004). In recent years, this trend appears to have increased (de Rugy, 2004), and prospects are uncertain for agreement on a FY 2005 budget resolution and a full set of appropriations bills. This could again necessitate spending authorizations through an omnibus spending bill, which in the past has resulted in an easing of fiscal discipline in order to secure passage.

Figure 8.Discretionary Outlays Proposed by the President vs. Actual Outlays

15. Expenditure discipline could be strengthened by reinstituting budget control mechanisms similar to those contained in the Budget Enforcement Act (BEA) that expired in 2002. Some of these were included in the Spending Control Act proposed by the administration, which would have required offsets for budget proposals increasing long-term unfunded liabilities and limited the scope for “emergency” legislation and other instruments used to circumvent the BEA in the late 1990s.41 Congress recently rejected this proposal, however, with some members expressing concern that it would have largely exempted tax cuts from mandatory offsets under pay-as-you-go (PAYGO) rules and reduced the period for scoring the budgetary impact of policy proposals from ten to five years. The administration was also seeking legislation to restore the “line-item veto”, which would provide the President with the authority to reject new individual appropriations, mandatory spending proposals, as well as a limited range of tax cuts.

16. While the budget would reduce nondefense spending by about $30 billion relative to “current services” estimates, considerably larger cuts can be envisaged. Rivlin and Sawhill (2004) identify a range of measures worth $68 billion (½ percent of GDP) that could help improve the quality of government spending without affecting major spending priorities (Table 2). These include cutbacks in agricultural, commercial, and trade subsidies, as well as reductions in other low-value government spending. Silvinski (2001) and Edwards (2004a) provide more far-reaching suggestions for terminating, privatizing, or devolving to states a wide range of federal programs, amounting to total savings of $300 billion (2½ percent of GDP) per year. While agencies such as the Army Corps of Engineers, the FAA, and others would be privatized, the bulk of savings would be achieved by eliminating the Departments of Education and Housing and Urban Development (Table 3). However, even the more limited measures proposed by the administration have raised concerns over their legislative viability (Greenstein and Kogan, 2004) and distributional impact (e.g., Steuerle, 2003).

Table 2.A “Better Government” Plan
Category of spending cutsAnnual saving

by 2014 ($ bn)
Subsidies23
of which: Agriculture11
State and local grants17
of which: Convert categorical grants into block grants7
Low-value investment20
of which: Manned space flight9
Improved efficiency, fraud reduction8
Total68
Table 3.A Proposal for Federal Expenditure Savings(In billions of U.S. dollars)
DepartmentFY 2004 OutlaysProposed ReductionsExamples for Areas of Expenditure SavingsReduction AmountType of

Reform
Agriculture77.729.7Farm Service Agency16.9Terminate
Risk Management Agency4.0Terminate
Commerce6.21.9Econ. Development Administration0.4Terminate
Education62.862.8Elem. and Secondary Education25.0Terminate/Devolve to States
Special Ed. and Rehab.12.4Devolve
Student Aid19.0Terminate
Energy20.66.0General Science3.4Terminate
Health and Human Services547.963.0Temporary Assist. for Needy Families18.9Devolve
NIH Applied R&D12.5Terminate
Homeland Security30.77.0State and Local Programs3.8Devolve
Housing and Urban Development46.246.2Low-Income Housing Assistance22.3Terminate
Community Development Block Grants6.0Terminate
Interior10.04.7Bureau of Indian Affairs2.2Terminate
Justice23.53.2State and Local Law Enforcement Assist.1.5Devolve
Labor60.07.1Employment and Training Adm.5.6Terminate
State11.32.3Andean Counterdrug Initiative1.0Privatize
Transportation58.011.6Amtrak and related1.5Privatize
Federal Aviation Administration9.5Privatize
Federal Highway Administrationn/aPrivatize
Federal Transit Administrationn/aPrivatize
Other Agencies and Activitiesn/a54.5Agency for International Development4.6Terminate
Army Corps of Engineers4.3Privatize
EPA-State and Tribal Assistance Grants4.0Devolve
Foreign Military Financing5.4Terminate
Excess military bases5.0Terminate
NASA14.6Terminate
Small Business Administration4.0Terminate
Total Expenditure Savings300.2

17. Shifting responsibilities and reducing federal transfers to the states are also among the options considered. This could, in principle, improve finances at the federal level and impose additional fiscal discipline on states. However, the bulk of federal transfers to states is being used to finance priority areas such as health care and education, and the scope for achieving savings on a general government basis may therefore be relatively small.42 Moreover, state and local governments have already gone through several rounds of cost cutting, following a severe post-2000 decline in revenues and the expansion of state responsibilities in the late 1990s. Indeed, states may come under increasing pressure to raise revenues to respond to a 7–8 percent annual trend increase in Medicaid spending, which already accounted for about a fifth of total state expenditure in 2002.

C. Tax Policy Options

18. Future tax policy will depend partly on the fate of the 2001–03 tax cuts and the increasing reach of the AMT. Most of the tax cuts implemented in recent years are slated to expire by the end of FY 2010 at the latest (Table 4), requiring new legislation to make them permanent. The FY 2005 budget has included such a proposal, but there is a likelihood that many tax cuts will continue to be extended by Congress on a temporary basis only. For illustrative purposes, the cost of making the tax cuts permanent is estimated at around 2 percent of GDP per year by FY 2014 (CBO, 2004; Gale and Orszag, 2004); if this were combined with permanently extending and indexing AMT relief, the cost would rise to about 3¼ percent of GDP ($500 billion) per year.

Table 4.FY 2005 Budget Proposals for Extending the 2001 and 2003 Tax Cuts
Enacted PolicyInformation ReportedPre-EGTRRAEGTRRAJGTRRAFY 2005 Budget
General Income and Estate Tax Cuts
Reduce top four income tax ratesTax rate28, 31, 36, 39.62001–03

2004–05

2006–10
27, 30, 35, 38.6

26, 29, 34, 37.6

25, 28, 33, 35
2003–1025, 28, 33, 352011 and on

25, 28, 33, 35
Create 10 percent bracketIncome taxed at 10 percent for married couplesN/A2001–07$12,0002003$14,0002005 and on
2008$14,0002004$14,300$14,300
2009–10Indexed
Repeal PEP and PEASEPercent reduction relative to pre-EGTRRA lawN/A2006–0733 percent2011 and on
2008–0966 percentRepeal
2010Repealed
Repeal estate taxExemption level, highest effective tax rate$675,0002002$1 million, 50 %2011 and on
60 percent… changing to …Repeal
2009$3.5 million, 45 %
2010Repeal
Increase AMT ExemptionExemption level (unindexed)$33,750 Single2001–04$35,750 Single2003–04$40,250 Single2005 only
$45,000 Married$49,000 Married$58,000 Married$40,250 Single
$58,000 Married
Reduce dividend tax ratesTax rateTaxed as ordinary income2003–075, 152009 and on
20080, 150, 15
Reduce capital gains tax ratesTax rate10, 20

(with exceptions)
2003–075, 152009 and on
20080, 150, 15
Children and Marital Status
Expand child creditMaximum credit amount (unindexed)$5002001–04$6002003–04$1,0002005 and on
2005–08$700$1,000
2009$800
2010$1,000
Expand standard deduction for married couplesDeduction for couples as percent of deduction for singles167 percent2005174 percent2003–04200 percent2005 and on
2006184 percent200 percent
2007187 percent
2008190 percent
2009–10200 percent
Expand 15-percent bracket for married couplesMaximum income as percent of maximum for singles167 percent2005180 percent2003–04200 percent2005 and on
2006187 percent200 percent
2007193 percent
2008–10200 percent
Expand EITC for married couplesIncrease beginning and end of phase-out.N/A2002–04$1,0002011 and on
2005–07$2,000Indexed
2008$3,000
2009–10Indexed
Saving
Raise traditional and Roth IRA contribution limitsContribution limit$2,0002002–04$3,0002011 and on
2005–07$4,000Indexed
2008$5,000
2009–10Indexed
Increase 401(k) contribution limitsContribution limit$10,0002002–06Raise $1,000 per year2011 and on
2006$15,000Indexed
2007–10Indexed
Increase IRA contribution limits for people over 50Additional allowable contributionsN/A2002–05$5002011 and on
2006–10$1,000$1,000
Increase section 401(k) contribution limits for people over 50Additional allowable contributions.N/A2002$1,0002011 and on
2003$2,000Indexed
2004$3,000
2005$4,000
2006$5,000
Create Roth 401(k)Contribution limitN/A2006–07$4,0002005–07$4,0002011 and on
2008$5,0002008$5,000Indexed
2009–10Indexed2009–10Indexed
Create Saver’s CreditEligible income range for married couple, credit rateN/A2002–06$0-30,000 50%Allow expiration
$30,000-32,500 20%
$32,500-50,000 10%
Education
Raise Education IRA contrib. limitsContribution limit$5002002–10$2,0002011 and on
$2,000
Increase eligibility for Education IRAIncome phaseout range$180,000-210,000 2002-10$190,000-220,0002011 and on
$190,000-220,000
Create deduction for education expensesEligible income cap for married couple, deduction limitN/A2002–03$130,000 $3,000Allow expiration
2004–05$130,000 $4,000
2006Expires
Expand deductible student loan interest paymentsEligible income cap range$45k–60k single2002$50k–65k single2011 and on Indexed
$90k–120k married$100k–130k married
2003–10Indexed
Create prepaid tuition programs programsN/AN/A2002–10Allows purchase of tuition creditsMake permanent
Sources: OMB (2004); Joint Committee on Taxation; and Gale and Orszag (2004).
Sources: OMB (2004); Joint Committee on Taxation; and Gale and Orszag (2004).

19. Although tax revenues may need to increase over the medium-term, reversing recent cuts in marginal income tax rates may not be optimal. The revenue effect of reversing the tax cuts would be substantial, but many analysts have argued that tax cuts are needed to offset bracket creep caused by rising real incomes and contribute to expenditure discipline. Moreover, although U.S. marginal income tax rates are currently not high by international standards, a comparison with other industrial countries suggests that U.S. taxation is primarily income-based (Box 1). Tax policy could therefore seek to preserve the efficiency-enhancing effects of the recent tax cuts through measures to broaden the tax base and increasing the share of consumption-based taxes.

20. There remains considerable scope for simplifying the income tax structure and broadening the tax base. In 2003, the U.S. personal income tax system has provided $675 billion (6.2 percent of GDP) worth of tax credits and exemptions, many of which are targeted at specific economic activities or particular groups of taxpayers. As documented in CEA (2003), among others, these tax expenditures add to the complexity of the U.S. tax system, increase compliance cost, and can give rise to unproductive behavior aimed at tax avoidance. The largest tax expenditures consist of exemptions for employer contributions to medical insurance premiums and health care, private pension contributions, mortgage interest payments, and investment income from life insurance policies (see Box 1). Eliminating some of these exemptions could be designed to generate significant revenues, restore some of the progressivity that the U.S. tax system lost in recent years, and improve allocative efficiency (Table 5).43 For example, the maximum mortgage amount on which interest is deductible from income could be gradually reduced from $1 million presently to limit tax expenditures on wealthier households. At the same time, proponents of health care reform have questioned the employer-based focus of U.S. health care insurance (Cutler, 2004), which suggests that reviewing tax incentives for corporate health care contributions could be part of a broader medical reform.

Table 5.Quantitative Impact of Selected Revenue Measures(Estimated annual value in 2014)
US$ billionPercent

of GDP
Revenue effect of reversing 2001 and 2003 reductions in marginal tax rates, child credits, capital gains, dividend taxation, and the estate tax.260
Personal tax expenditures (total value, 2009)756
Of which: Exclusion of employer contributions for medical insurance1501⅓
Net exclusion of pension contributions and earnings136
Deductibility of mortgage interest on owner-occupied homes90¾
Deductibility of charitable contributions46
Exclusion of interest on life insurance savings30¼
Corporate tax expenditures (total value, 2009)25¼
Revenue effect of introducing a 4 percent federal VAT3002
Memorandum item:
Projected fiscal deficit excluding Social Security over the medium-term.3½-4
Sources: CBO (2003); OMB (2004); Rivlin and Sawhill (2004); and Fund staff calculations.
Sources: CBO (2003); OMB (2004); Rivlin and Sawhill (2004); and Fund staff calculations.

Box 1.Tax Revenue in the United States: An International Comparison

Reflecting the smaller size of the public sector compared to other industrial countries, U.S. general government revenues are relatively low. Prior to recent tax cuts, the revenue-to-GDP ratio reached a high of almost 30 percent in 2000, but has since dropped to 26 percent, the lowest among the G-7.

General Government Tax Revenue, 2003

Income taxes

Compared to most other countries, the United States relies heavily on direct taxes. Almost half of the general government tax revenue comes from income taxes, the highest level in the G-7 and well above the OECD average of 36 percent. Individual income taxes contribute over 40 percent of revenue, greatly exceeding the G-7 average of 28 percent. Direct taxes on corporations raise 8 percent of revenues, near the G-7 average.

U.S. reliance on direct taxes is even more pronounced at the central government level, as fully 90 percent of federal tax revenues (excluding taxes dedicated to Social Security and Medicare) are from these sources. Other G-7 central governments draw about 50 percent of revenue from direct taxes and an almost equal 40 percent from taxes on goods and services. Because of the lower tax overall burden in the United States, however, income taxes only account for 14 percent of GDP, near the G-7 average of 13 percent.

Despite the heavy reliance on direct taxes, top U.S. marginal tax rates on personal income are the second-lowest in the G-7. While France, Germany, and Japan apply lower rates to taxable income below US$25,000, the U.S. tax system applies a more generous treatment to families, including through exemptions and tax credits, and the highest marginal tax rate is reached at higher levels of income than in most other countries. A married couple with two children and income of an average production worker pays 60 percent of the taxes paid by a single taxpayer with no children and the same income, the most preferential ratio in the G-7.

General Government Tax Revenue, 2001 1/(Percent of total)
Income,

profits, and

capital gains
Social

security
PropertyGoods

and

services
Other
Federal Countries 2/42 [58]24625 [36]3
Australia56 [67]0929 [31]6
Canada48 [75]151025 [25]3
Germany29 [40]40229 [60]0
United States49 [91]251116 [7]0
Other Countries 2/33 [50]30825 [41]3
France25 [38]36725 [50]6
Italy34 [57]29526 [39]6
Japan33 [56]381019 [38]0
United Kingdom40 [51]171231 [39]0
G-7 2/37 [58]28824 [37]2
Source: OECD, Revenue Statistics.

Central government revenues in brackets.

Unweighted average. Average for federal countries includes Austria, Belgium, and Switzerland.

Source: OECD, Revenue Statistics.

Central government revenues in brackets.

Unweighted average. Average for federal countries includes Austria, Belgium, and Switzerland.

Taxable Income and Marginal Tax Rates

The phase-out of tax benefits makes marginal tax rates somewhat less favorable at lower income levels, as the marginal labor tax wedge for the family in the previous example is 54 percent, compared to 34 percent for the single person. The marginal labor tax wedges in other G-7 countries average 50 percent and 47 percent, respectively.

Tax rates on corporate and capital income display relatively little variance across countries. In 2003, effective average corporate tax rates in the G-7 ranged from 26 percent in the United Kingdom to 37 percent in Japan, with the U.S. at just under 33 percent (see Devereux and others, 2002, for methodology). Statutory rates, including local taxes, ranged from 30 percent in the U.K. to just over 40 percent in Italy and Japan, with the U.S. at 39 percent. Effective tax rates on capital range from 21 percent in Germany to 37 percent in Canada, with the U.S. at 27 percent (before the recent tax cuts), near the OECD average (Carey and Rabesona, 2002).

Federal tax expenditures greatly reduce individual and corporate income tax revenue. Tax expenditures comprise about 45 percent of potential individual income tax revenues, and 40 percent of potential corporate income tax revenues. While tax expenditures targeted at corporations are projected to decline to about 10 percent after the expiration of an accelerated depreciation provision, other tax expenditures will remain high. Many of the costliest tax breaks are focused on health insurance and pension contributions. Housing is also treated more favorably than in other G-7 countries. The United States provides a large tax break for mortgage interest, state and local property taxes are deductible at the federal level, and up to $500,000 in capital gains are tax-exempt upon the sale of a house.

Individual Income Tax Expenditures

In billion U.S. dollars and percent of GDP, 2003

Other Direct Taxes

The U.S. proportion of revenue raised from Social Security contributions and property taxes is close to that of other countries. Social Security contributions accounted for 25 percent of revenue in 2001, near the G-7 average of 28 percent. Eleven percent of revenue came from property taxes, similar to Canada, Japan, and the United Kingdom, although the Euro area countries generally derived much less revenue from this source.

Taxes on Goods and Services, 2001(Percent of GDP)
State and

Local
CentralTotal
Federal Countries 1/3.15.78.8
Australia1.17.78.8
Canada5.13.68.7
Germany3.86.810.6
United States3.70.84.6
Other Countries 1/1.08.59.5
France1.59.310.8
Italy1.29.510.8
Japan1.43.75.1
United Kingdom0.011.311.3
G-7 1/2.46.48.8
Source: OECD, Revenue Statistics.

Unweighted average. Average for federal countries includes Austria, Belgium, and Switzerland.

Source: OECD, Revenue Statistics.

Unweighted average. Average for federal countries includes Austria, Belgium, and Switzerland.

Taxation of Goods and Services

Goods and services carry a significantly lower tax burden in the U.S. than in other countries. Taxes on goods and services provide 16 percent of general government revenue, the lowest level in the OECD and about two-thirds the G-7 average. Taxes on both general consumption and on specific goods and services are the lowest in the OECD. The absence of a national VAT is the main factor in this difference, with U.S. state and local governments relying more on goods and services than their counterparts in other federal countries. U.S. state and local governments draw 40 percent of revenues from taxation of goods and services, and 30 percent each from property taxes and taxes on income, profits, and capital gains.

21. There is also ample room to broaden the corporate tax base. The administration estimates tax expenditures benefiting corporations to cost $85 billion in FY 2005, an amount that is expected to essentially halve as depreciation schedules for newly purchased capital goods expire by end-December. Although these tax expenditures pale in comparison to those for households, the corporate income tax system has been characterized by a widening gap between corporate book and taxable profits. Desai (2003) finds that about half of the increase may be due to unexplained factors, consistent with abounding anecdotal evidence of companies exploiting loopholes to shift income to low-tax jurisdictions, including offshore destinations, or avoid taxation altogether. Potential revenue gains from tightening tax regulations and stepping up enforcement of existing rules are hard to estimate, but Desai’s simulations indicate that, as of 2000, closing the gap between book income and taxable profits could have brought an additional $130 billion in corporate income under the tax net. Simplifying the existing tax system would also reduce compliance costs and discourage rent-seeking behavior.44

22. Raising energy taxes could yield fiscal and other benefits. From an international perspective, energy use in the United States is relatively lightly taxed, even accounting for geographical and climatic idiosyncrasies of the U.S. economy (Figure 9). Introducing higher energy taxes could raise fiscal revenues as well as help encourage more efficient U.S. energy use. For example, estimates suggest that raising gasoline taxes by 20 cents per gallon could yield around ¼-½ percent of GDP in revenues, although a part of this amount might be used to alleviate the impact of higher prices on certain energy users (e.g., rural households) and secure social acceptance (Prust and Simard, 2004). The overall macroeconomic impact would likely be relatively modest, in part because reduced demand could have a beneficial impact on global oil prices.

Figure 9.Prices and Taxes of Premium Unleaded Gasoline

Source: OECD, IEA Statistics.

23. Finally, a federal VAT or sales tax could be considered, providing a source of revenue that is considered to have the least distortive impact on economic activity. Experience from other industrial countries suggests that a federal VAT could yield about ½ percent of GDP per percentage point (somewhat below the theoretical maximum corresponding to the two-thirds share of consumption in national income). By 2014, a VAT rate of 4 percent could therefore contribute as much as $300 billion in additional revenues.45 Given the highly diverse tax systems among the states, a VAT would need to be carefully designed to gain widespread acceptance, contribute to economic efficiency, and limit transition costs (e.g., Keen, 2001). Nevertheless, a VAT could help bring services—which are largely sales-tax exempt—under the tax net, improve intergenerational equity by implicitly taxing retiree wealth, and provide a flexible and relatively efficient means to respond to future budgetary shortfalls.

D. Reforming Social Security and Medicare/Medicaid

24. Without providing an alternative to long-term fundamental reform of the Social Security and Medicare programs, more immediate measures could be taken to improve their financial position. Reforms of entitlement programs have traditionally protected workers in or near retirement by phasing in changes over a long time horizon, sometimes a decade or more. Nevertheless, relatively marginal changes could be effected over a shorter time horizon without significantly affecting the underlying structure of the programs. This could help delay the time when the Social Security and Medicare trust funds are expected to run out of funds and provide greater scope for the implementation of broader reforms.

25. Social security benefits could be more closely aligned with changes in the cost of living and improvements in life expectancy (Greenspan, 2004; Diamond and Orszag, 2004). Social Security benefits have automatically been adjusted to keep pace with increases in the Consumer Price Index, which has been found to overstate growth of the cost of living of the population as a whole. Adjusting benefit levels in line with a chained consumer price index computed by the Bureau of Labor Statistics would slow the growth of benefits while preserving the principle that they be maintained in real terms (Table 6). Moreover, although the increase in the Social Security retirement age from 65 to 66 years will be completed in 2005, the shift to 67 years is only slated to take place between 2017 and 2022. With longevity trends continuing to surprise on the upside, the next phase of the increase in the retirement age could be advanced.

Table 6.Quantitative Impact of Selected Social Security and Medicare Reforms(Estimated annual value in 2014)
US$

billion
Percent

of GDP
Budgetary impact of limited Social Security, Medicare, and Medicaid reform74½
Of which: Improved consumer price index adjustment17
Raise retirement age in 20122
SMI premium increase16
Raise earnings ceiling for Social Security payroll tax to include 90 percent of taxable earnings53¼
Sources: Rivlin and Sawhill (2004); and Fund staff calculations.
Sources: Rivlin and Sawhill (2004); and Fund staff calculations.

26. Measures to broaden the burden of Social Security premiums could also be considered. The payroll tax used to finance Social Security is currently 12.4 percent on earnings up to $87,900, a ceiling that is adjusted annually for growth in average wages. Following the 1983 reforms, some 90 percent of covered earnings were under the payroll tax ceiling, but shifts in the income distribution have since reduced that number to around 85 percent (Rivlin and Sawhill, 2004). Rather than increasing payroll contribution rates, about ¼ percent of GDP in additional revenues could be garnered by restoring the initial 90 percent ratio (equivalent to increasing the payroll tax ceiling to about $130,000 in 2004).

27. Barring a broader consensus on health care reform, the scope for significant savings in the Medicare and Medicaid systems is likely to be relatively limited. Rivlin and Sawhill (2004) suggest a number of expenditure cuts that would yield up to ¼ percent of GDP in savings, involving stepped-up pressure on state governments and health care providers to seek greater operational efficiencies. The largest single element of their plan consists of reducing subsidies for subscribers to the Supplemental Medical Insurance (SMI) part of Medicare, leading to a hike in premium levels. Premiums were initially set in 1965 to cover half of SMI costs, but subsequent legislation increased the share of general revenues to account for 75 percent as of 1997. The 2003 Medicare Reform Act included provisions to reduce the subsidy element to as low as 20 percent for high income earners, but estimates suggest that only 5–6 percent of all Medicare beneficiaries would be affected by the reforms. Reducing the subsidy to 65 percent across the board would yield about $16 billion (0.1 percent of GDP) by 2014.46

E. Conclusion

28. This chapter has presented a range of fiscal options that could help prepare the U.S. fiscal system for the impending demographic transition. These measures would help reduce the budget deficit over the medium-term in a manner that would minimize the impact on, or even boost, economic efficiency and long-term growth prospects. This paper does not support a particular course of fiscal action, as there are obviously many combinations of measures possible (see Rivlin and Sawhill, 2004, for three fundamentally different consolidation scenarios). However, the size of the U.S. fiscal gap suggests that both expenditure and revenue measures will eventually be needed, in part because many of the factors that supported consolidation in the 1990s are no longer in place.

References

Prepared by Martin Mühleisen and Andrew Swiston.

The fiscal year runs from October 1 to September 30.

In 1983, Congress enacted pension reform measures, including a gradual increase from 65 to 67 in the full retirement age that is being phased in through 2022.

Less adjustment would be needed if the economy grew stronger than expected, with the deficit falling an estimated 1½ percent of GDP for each ½ percentage point increase in the potential growth rate.

This paper only discusses fiscal measures needed to return the budget to balance over the medium-term. Measures to restore long-run budget sustainability, including offsets for the rising cost of entitlement spending, have recently been estimated to amount to some 7–10 percent of GDP (Gokhale and Smetters, 2003; Auerbach, Gale, and Orszag, 2004).

Up to one-half of the increase in the post-2000 deficit was the result of economic factors, however, with the loss of bubble-induced capital gains revenues having no parallels in the 1980s (Gale and Orszag, 2004; Mühleisen and Towe, 2004).

Nondefense discretionary spending declined by 13½ percent during FY 1981–84, compared to an increase of over 20 percent between FY 2001–04 (de Rugy and DeHaven, 2003). Discretionary spending is controlled by annual appropriations acts. Mandatory spending is provided by permanent law and does not require annual appropriations to ensure the continuation of spending.

The 1986 Tax Reform Act included a further reduction in marginal income tax rates, but its revenue impact was broadly neutral as a result of base broadening measures (Tempalski, 2003)

See Chapter IV in this paper. Some analysts expect AMT revenues to defray the costs of about one third of recent tax cuts (Burman et al., 2003).

Yeaple and Golub (2004) found evidence that the provision of public infrastructure is associated with total factor productivity differences across countries. For the United States, Zegeye (2000) finds a small but positive impact of public infrastructure on output and productivity at the state and county level.

See Kell (2004) for a discussion of the BEA’s effectiveness in curbing expenditures in the 1990s.

While some analysts point out that grants to states have increased from 8 percent of federal spending in FY 1960 to 18 percent in FY 2004 (Edwards, 2004b), others have suggested that federal policies have contributed to fiscal problems at the state level in recent years (Lav and Brecher, 2004).

Some analysts have suggested that the 2001–03 tax cuts have been highly regressive in nature and, depending on the way they would eventually be financed, may indeed lead to an increased economic burden on low-income households (e.g., Gale and Orszag, 2004).

Existing inefficiencies in the corporate tax code could be increased under current House and Senate versions of the bill to repeal $5 billion worth of export subsidies provided under the Foreign Sales Corporation Act (FSC/ETI). The bills would offer up to $167 billion in tax relief over 10 years, which may only be partly offset by revenue-raising measures.

Contrary to the domestic debate on the VAT, which is often centered around replacing the existing system of income taxes with a VAT, this paper suggests to use the VAT as a complementary revenue source given its regressive nature.

In addition to the introduction of Health Savings Accounts by the administration, other suggestions to strengthen market-based principles by providing Medicare participants with greater choice have cited the Federal Employees Health Benefit Plan (FEHBP) as an example (e.g., Francis, 2003). Although potentially large, the magnitude of savings for introducing an FEHBP-type approach nationwide remain yet to be specified.

Other Resources Citing This Publication